Not surprisingly, the effect of shorting restrictions in various European stock markets failed to have the intended effect – or rather, the effect lasted only for a few days. Once the shorts were finished covering, everybody went back into 'sauve qui peut' mode and the selling immediately resumed with great gusto. Could anyone have known? As we noted at the time, 'we wonder why the authorities even bother'. Such restrictions have never stopped a decline from unfolding and there is a lot of historical evidence that argues that they in fact exacerbate declines. Numerous studies on such bans have all come to the same conclusion: they don't work.
This makes sense, as they reduce market liquidity and in fact remove an important source of buying power from the market. After all, shorts need to eventually buy back what they shorted if they want to take their profits. Moreover, restricting the shorting of specific stocks that are components in indexes that also trade in the form of futures contracts inhibits index arbitrage. On expiration Friday, French regulators saw themselves forced to temporarily remove the just introduced shorting restrictions again for this very reason.
“France relaxed a ban on selling banks short, trying to calm index futures traders concerned the rule would keep them from exchanging contracts when they expire today.
Investors who are short index futures that include bank shares can replace the holdings with new contracts, according to the AMF, France’s financial regulator. Speculation the ban would prevent that may have contributed to volatility yesterday, when European stocks plunged the most since March 2009.
“They really should have thought about that earlier,” said Trung-Tin Nguyen, a hedge-fund manager at TTN AG in Zurich. “If you want to change the rules of the game, then do it right.”
In a short sale, speculators borrow shares and sell them, betting they will be able to purchase them later at a lower price. France prohibited new short positions on financial stocks last week after Societe Generale (GLE) SA, the nation’s second-biggest bank, plunged the most since 2008.
Adding to concern yesterday were rules in the original ban designed to quash so-called synthetic positions in which traders bet against banks by shorting an index and buying every non- financial stock it contains. Some brokerages insisted that customers selling futures on gauges proved that they owned financial stocks, according to e-mails sent to clients and obtained by Bloomberg News.
The Stoxx Europe 600 Index plummeted 4.8 percent yesterday as U.S. economic data trailed forecasts, two Federal Reserve officials said the central bank shouldn’t act to protect stock investors and Swedish regulators warned that lenders are unprepared for a freeze in money markets. Societe Generale slid 12 percent as the Wall Street Journal said that U.S. regulators are stepping up scrutiny of Europe’s largest lenders.
“Any uncertainty about what products can be traded, when and where, is bad for the market,” Richard Perrott, exchange and diversified financials analyst at Berenberg Bank in London, said in an interview yesterday. “There was huge confusion today what participants could and couldn’t do, which isn’t helpful when there are large share price movements. Potentially the regulators didn’t think this through.”
Futures on France’s CAC 40 Index (CAC) expiring tomorrow plunged 5.6 percent to 3,071.5 at 8:35 p.m. in Paris yesterday.”
(emphasis added)
You bet the regulators didn't think this one through. It's a wonder they haven't yet banned credit default swaps as it were, since the buyers of CDS evidently can only profit from 'negative outcomes' (note that even George Soros, who really should know better, thinks they are somehow odious instruments). So what about the sellers of such swaps? Shouldn't they be punished for being unduly optimistic? Kidding aside, here is what would probably happen if trading in CDS on sovereign debt and or corporate debt were banned: the underlying bonds would crash before our vaunted regulators could ask 'what happened'.
As an aside, market places elsewhere immediately reacted to the European regulators latest exercise in shooting themselves into the face by rolling out products that would allow people to take the positions that they could no longer take in Spain, Italy, France and Belgium. As per this press report:
“A small U.S. derivatives exchange on Thursday rolled out contracts that allow traders to take bearish positions on European stocks affected by new short-selling restrictions, highlighting the tough task regulators can face in trying to limit market activity.
OneChicago LLC developed the contracts in the week since the tougher short-selling rules were introduced in an effort to limit market declines, with products linked to exchange-traded funds composed of stocks listed in France, Spain, Italy and Belgium.
"This is another way to get exposure to those markets without touching those foreign exchanges," said David Downey, chief executive of OneChicago. "When we heard about the short-selling bans in those countries I instructed our staff to go through and find any ETFs based on those countries' markets that we did not currently list for trading." Downey said in an interview that he didn't anticipate a sharp upswing in volume, but large banks and other financial institutions with long exposures to the affected European markets would be potential users.”
Note here who Mr. Downey identified as the 'potential users' of these new instruments – institutions wishing to hedge their exposure. Kudos by the way to the CLSA publication 'Greed & Fear' that has advocated for two years or longer that investors should 'hedge their long exposures by shorting Western financial stocks'. This has by now turned out to have been excellent advice indeed.
As an aside, has anyone else taken note of the fact that what usually makes these lists of shorting bans are bank stocks? Why bank stocks, and not, for instance, mining stocks? The answer is of course that we remain essentially in a crisis of the fractionally reserved banking system. Considering the huge leverage of European banks (ratios of tangible capital to assets of 1:50 are the norm rather than the exception) not a whole lot must go wrong. Alas, a lot of things obviously have been going wrong and continue to do so.
